- Criteria for Successful Investing
- Risk Profile Charts
- The Definition of an Option
- The Valuation of Options
- Intrinsic and Time Value for Calls
- Intrinsic and Time Value for Puts
- The Seven Factors that Influence an Option's Premium
- Risk Profile Charts for Call Options
- Risk Profile Charts for Put Options
- Memory Tips for Long and Short Calls and Puts
- Basic Risk Profiles Summary
- Notation Standard for the Examples
- Chapter 1 Major Learning Points
This chapter is from the book
This chapter is from the book
This chapter is from the book
Risk Profile Charts
Do you know what buying an asset such as a stock or a future looks like? To find out, we need to learn how to draw a risk profile chart. This is the cornerstone on which we build far more complex strategies, so it’s important to understand this right now.
Example 1.1.
Consider a stock XYZ Inc. You buy the stock for $25.00.
- The X-axis is the stock price, with the price rising as the line moves right.
- The Y-axis is your profit for the trade.
- The 45° diagonal line is your risk profile for the trade. As the price of the stock (or underlying asset) rises, so does your profit in this example. So when the asset price rises to $50, you make $25 of profit:
|
Current price |
– |
Buy price |
= |
Profit (loss) |
|
$50 |
– |
$25 |
= |
+$25 |
|
$10 |
– |
$25 |
= |
($15) |
Chart 1.1. • Buying an asset risk profile.
)
Steps to Creating a Risk Profile Chart
Step 1 • Y-axis for profit/loss position
Step 2 • X-axis for underlying asset price range
)
Step 3 • Breakeven line
)
Step 4 • Risk profile line
)
Now that you know what buying an asset looks like, you can move straight onto what shorting an asset looks like. Shorting simply means selling something that you don’t already own.
Remember that when you short, you can lose an unlimited amount as the asset price rises, and your maximum profit is the shorted price. To make maximum profit from a short stock position, the asset would have to fall to zero.
Chart 1.2. • Shorting an asset risk profile.
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So now that you know how to draw the most basic risk charts, let’s talk about options.